Sovereign debt default

A sovereign default (or public default) is defined as the failure of a government to meet a principal or interest payment on the due date (or within the specified grace period). These episodes include instances in which rescheduled debt is ultimately extinguished in terms less favorable than the original obligation.[1]

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External debt default

External debt crises involve outright default on a government’s external debt obligations—that is, a default on a payment to creditors of a loan issued under another country’s jurisdiction, typically (but not always) denominated in a foreign currency, and typically held mostly by foreign creditors. Argentina holds the record for the largest default; in 2001 it defaulted on more than $95 billion in external debt. In the case of Argentina, the default was managed by reducing and stretching out interest payments. Sometimes countries repudiate the debt outright, as in the case of Mexico in 1867, when more than $100 million worth of peso debt issued by Emperor Maximilian was repudiated by the Juarez government. More typically, though, the government restructures debt on terms less favorable to the lender than were those in the original contract (for instance, India’s little known external restructurings in 1958–1972).

Although the time of default is classified as a crisis year, in a large number of cases the final resolution with the creditors (if it ever was achieved) seems interminable. Russia’s 1918 default following the revolution holds the record, lasting sixty-nine years. Greece’s default in 1826 shut it out of international capital markets for fifty-three consecutive years, and Honduras’s 1873 default had a comparable duration.[1]

Domestic debt default

Domestic public debt is issued under a country’s own legal jurisdiction. In most countries, over most of their history, domestic debt has been denominated in the local currency and held mainly by residents. Domestic debt crises typically occur against a backdrop of much worse economic conditions than the average external default. Usually, however, domestic debt crises do not involve powerful external creditors and are usually less noticed.

The list of defaults by Reinhart and Rogoff from 1800 to 2007 includes more than 70 cases of domestic defaults, compared to 250 defaults on external debt. (Noting, however, that domestic defaults are far more difficult to detect.) The data on domestic debt of most countries lacks transparency. Even the United States have an extraordinarily opaque accounting system, replete with potentially costly off-budget guarantees.

Mexico had nearly defaulted in 1994–1995 on its domestic government debt (in the form of tesobonos, mostly short-term debt instruments repayable in pesos linked to the U.S. dollar), until the country was bailed out by the International Monetary Fund and the U.S. Treasury; this debt was widely held by nonresidents. Since 1980, Argentina has defaulted three times on its domestic debt. The two domestic debt defaults that coincided with defaults on external debt (1982 and 2001) attracted considerable international attention. However, the large-scale 1989 default that did not involve a new default on external debt—and therefore did not involve nonresidents—is scarcely known in the literature. There were also many defaults on domestic debt that occurred during the Great Depression of the 1930s.

Some of the domestic defaults that involved the forcible conversion of foreign currency deposits into local currency have occurred during banking crises, hyperinflations, or a combination of the two (like defaults in Argentina, Bolivia, and Peru).[1]

Inflation

Unexpected increases in inflation are the de facto equivalent of outright default, for inflation allows all debtors (including the government) to repay their debts in currency that has much less purchasing power than it did when the loans were made.[1] Default through inflation became more commonplace over the years as fiat money displaced coinage as the principal means of exchange. This can probably be explained by a change in the willingness of governments to expropriate through various channels and the abandonment of a gold (or other metallic) standard.

Inflation conditions often continue to worsen after an external default. Shut out from international capital markets and facing collapsing revenue, governments that have not been able to restrain their spending have, on a recurring basis, resorted to the inflation tax, even in its most extreme hyperinflationary form.

As Reinhart and Rogoff note, the extensive scholarly literature on inflation has been silent on the connection of inflation and domestic defaults.[2]